Learning Objectives What is revenue recognition principle under the accrual-basis accounting?

1. Accrual Accounting and Income Determination (Sources: Financial Reporting & Analysis By Revsine, Collins, Johnson and Mittelstaedt and Intermediate Accounting by Kieso Weygandt and Warfield) Learning Objectives • What is revenue recognition principle under the accrual-basis accounting? • How to apply the matching principle to expense recognition under the accrual-basis? . • How is income measured under the accrual-basis? • What is the cash-basis accounting?

2. Learning Objectives (Contd.) • What are the distinctions between cash-basis and accrual-basis earnings? • Why is accrual-basis income generally a better measure of operating performance? • Income statement format and classification. • How to report a change in accounting principle, accounting estimate, and accounting entity. • What is comprehensive income?

3. Learning Objectives : • What is the revenue recognition principle under the accrual-basis accounting? • How to apply the matching principle to expense recognition under the accrual-basis? . • How is income measured under the accrual-basis?

4. Step 1:Revenuer ecognition Step 2:Expense matching Step 3:Income Recognition Net income = Revenues - Expenses Market the product Collect cash Receive order Deliver product Negotiate production contract Order material Manufactureproduct Measuring Profit ( Net income) Performance:When to recognize revenues and expenses under the GAAP (the accrual-basis)? Operating Cycle

5. Accrual Basis Accounting – Income Measurement • Step1: Revenuesare “recognized” (recorded) when: • Earned: The seller has performed a service or conveyed an asset to the buyer; and • Measurable (Realizable): The value to be received for that service or asset can be measured with a high degree of reliability and the collection is reasonably assured. • Step 2: Expenses are “matched” to revenues. • Step 3: Net income = Revenues - Expenses

6. Step 1:Determine the amount of revenue to be recorded (revenue recognition). Time of sale is used in most industries Condition 1: The critical event in the process of earning the revenue has taken place. (Earned) Condition 2: The amount of revenue that will be collected is reasonably assured and is measurable with a reasonable degree of reliability. (Measurability)

7. Step 2: Matching expenses with revenues • Matching Principle: if revenues are recognized in x1 period, all related expenses (including both traceable and period costs) should be recognized in the same period.

8. Step 2: Matching expenses with revenues (contd.) • Traceable costs: The costs which can be easily traced to the revenues. These traceable costs also called product costs (i.e., the cost of goods sold). • Period costs: These costs are more difficult to quantify their contribution to revenues of a particular period. • Thus, period costs are expensed in the period when they occur or consume (e.g., advertising costs, salary costs).

9. This example illustrates how product (traceable) costs are matched with revenues. Matching Traceable costs (expenses) with Revenues:(Cory TV and Appliance )

10. Expense Period costs when they are consumed Suppose Cory TV also buys radio advertising for a monthly cost of $120 beginning in February. This is a period cost (not product cost). Period costs are expensed in the period when they are consumed.

11. Learning Objective : • What is the cash-basis accounting? • What are the distinctions between cash-basis and accrual-basis income? • Why is accrual-basis income generally a better measure of operating performance?

12. Cash Basis Income Measurement Revenues are recognized upon the receipts of cash. Expenses are recognized when they are paid in cash. Cash flow inflows and outflows do not reflect the true economic benefits (i.e., revenues) or efforts (i.e., expenses). Revenues and expenses do Not match.

13. Summary of Accrual vs. Cash Basis Accounting • Accrual-basis accounting: Revenues are recognized when they earned and realizable, not wait until cash is collected. Expenses are recognized when they occur or are consumed, not wait until they are paid for. • Cash-basis accounting: The accountant does not record a transaction until cash is received or disbursed.

14. Cash Versus Accrual Accounting • Carter Company has sales on account totaling $100,000 per year for three years. Carter collected $50,000 in the first year and $125,000 in the second and third years. The company prepaid $60,000 for three years’ rent in the first year. Utilities are $10,000 per year, but in the first year only $5,000 was paid. In the second year, the total of $15,000 was paid for the utilities. Payments to employees are $50,000 per year.Let’s look at the cash flows.

15. Cash Basis Accounting Cash flows in any one year may not be a predictor of future cash flows.

16. Accrual Accounting

17. Cash Basis vs. Accrual Basis Accounting Looking at the cash-basis and the accrual-basis results for Carter Company, which method would you want to use if you were asked to make predictions about future years’ operating performance? Accrual-basis earnings is a more accurate measure of performance than is cash- basis earnings.

18. Cash Basis vs. Accrual Basis Accounting Information about enterprise earnings and its components measured by accrual accountinggenerally provides a better indication of enterprise performance than does information about current cash receipts and payments. ( SFAC No. 1)

19. Example: Whole Foods Market Inc. Discrepancies between earnings (net income) and cash flows Note: Amounts are in millions.

20. Learning Objective : Income statement format and classification

21. Income Statement Usefulness • Evaluate past performance. • Predicting future performance. • Help assess the risk or uncertainty of achieving future cash flows. LO 1 Understand the uses and limitations of an income statement.

22. Income Statement Limitations • Companies omit items that cannot be measured reliably. • Income is affected by the accounting methods employed. • Income measurement involves judgment. LO 1 Understand the uses and limitations of an income statement.

23. Single-Step Format The single-step statement consists of just two groupings: Revenues Expenses Net Income Single- Step No distinction between Operating and Non-operating categories. LO 2 Prepare a single-step income statement.

24. Multiple-Step Format The presentation divides information into major sections. 1. Operating Section 2. Nonoperating Section 3. Income tax LO 3 Prepare a multiple-step income statement.

25. Reporting Irregular Items • Irregular items fall into six categories • Unusual gains and losses. • Discontinued operations. Reported in the • Extraordinary items. Income Statement • Changes in accounting principle. • Changes in estimates. • Corrections of errors • Unusual gains and losses, discontinued operation results and extraordinary items are also referred to as transitory items. LO 4 Explain how to report irregular items.

26. Reporting Irregular Items • Unusual Gains and Losses • Material items that are unusual or infrequent, but not both, should be reported in a separate section just above “Income from continuing operations before income taxes” as part of the above the line income. • Examples can include: • Write-downs of inventories, equipment, etc. • Foreign exchange transaction gains and losses • Restructuring charges • Gains or losses from sale of investments • The Board prohibits net-of-tax treatment for these items. LO 4 Explain how to report irregular items.

27. Multiple-Step Format The presentation divides information into major sections. 1. Operating Section 2. Nonoperating Section 3. Income tax LO 3 Prepare a multiple-step income statement.

28. Income statement format and classification Multi-step income statements subdivide income in a manner that helps analysts to forecast future operating cash flows. This format: Separates operating from nonoperating transactions . Separates “transitory” income items from those believed to be “sustainable” or “ permanent” (likely to be repeated).

29. Operating vs. Non-Operating Items • Operating transactions: relating to the day-to-day operations. • Examples: sales, cost of sales, selling, general and administrative expense, research and development costs, etc. • Non-operating: interest revenue, dividends revenue, interest expense, unusual items, etc.

30. Reporting Irregular Items other than the Unusual Items • Discontinued Operations occurs when, • (a) company eliminates (discontinues) the • results of operations and • cash flows of a component. • there is no significant continuing involvement in that component. • Amount reported “net of tax.” • Note: A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity (SFAS 144). LO 4 Explain how to report irregular items.

31. Reporting Irregular Items • Discontinued Operations (contd.): • Examples of a component: a reportable segment, an operating segment, a reporting unit, a subsidiary, or an asset group. • Other required treatment: 1) must restate all presented periods with the discontinued operations separated reported, 2)the identity of the business segment and the details of disposal must be disclosed in footnotes LO 4 Explain how to report irregular items.

32. Reporting Discontinued Operations –Component Sold Illustration:KC Corporation had after tax income from continuing operations of $55,000,000 in 2008. During 2008, it disposed of its restaurant division at a pretax loss of $270,000. Prior to disposal, the division operated at a pretax loss of $450,000 in 2008. Assume a tax rate of 30%. Prepare a partial income statement for KC. Income from continuing operations $55,000,000 Discontinued operations: Loss from operations, net of $135,000 tax 315,000 Loss on disposal, net of $81,000 tax 189,000 Total loss on discontinued operations 504,000 Net income $54,496,000 LO 4 Explain how to report irregular items.

33. Reporting Discontinued Operations –Component Sold Discontinued Operations are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 4 Explain how to report irregular items.

34. Reporting for Components Held For Sale An “impairment loss” if the carrying value of the assets of the component is more than the fair value minus cost to sell. Operating income or loss of the component from the beginning of the reporting period to the end of the reporting period. Reporting Discontinued Operations- Component Held for Sale

35. Reporting Discontinued Operations – Componet Held for sale Two components of discontinued operations are reported: Gain or loss from operations Impairment loss • .

36. Reporting Irregular Items • Extraordinary items are nonrecurring material items that differ significantly from a company’s typical business activities. • Extraordinary Item must be both of an • Unusual Nature and • Occur Infrequently • Company must consider the environment in which it operates. • Amount reported “net of tax.” LO 4 Explain how to report irregular items.

37. Reporting Extraordinary Items Are these items Extraordinary? (a) A large portion of a tobacco manufacturer’s crops are destroyed by a hail storm. Severe damage from hail storms in the locality where the manufacturer grows tobacco is rare. (b) A citrus grower's Florida crop is damaged by frost. (c) A company sells a block of common stock of a publicly traded company. The block of shares, which represents less than 10% of the publicly-held company, is the only security investment the company has ever owned. YES NO YES LO 4 Explain how to report irregular items.

38. Reporting Extraordinary Items Are these items Extraordinary? (d) A large diversified company sells a block of shares from its portfolio of securities which it has acquired for investment purposes. This is the first sale from its portfolio of securities. (e) An earthquake destroys one of the oil refineries owned by a large multi-national oil company. Earthquakes are rare in this geographical location. (f) A company experiences a material loss in the repurchase of a large bond issue that has been outstanding for 3 years. The company regularly repurchases bonds of this nature. NO YES NO LO 4 Explain how to report irregular items.

39. Reporting Extraordinary Items Illustration:KC Corporation had after tax income from continuing operations of $55,000,000 in 2007. In addition, it suffered an unusual and infrequent pretax loss of $770,000 from a volcano eruption. The corporation’s tax rate is 30%. Prepare a partial income statement for KC Corporation beginning with income from continuing operations. Income from continuing operations $55,000,000 Extraordinary loss, net of $231,000 tax 539,000 Net income $54,461,000 ($770,000 x 30% = $231,000 tax) LO 4 Explain how to report irregular items.

40. Reporting Extraordinary Items Extraordinary Items are reported after “Income from continuing operations.” Previously labeled as “Net Income”. Moved to LO 4 Explain how to report irregular items.

41. Reporting Irregular Items Reporting when both Discontinued Operations and Extraordinary Items are present. Discontinued Operations Extraordinary Item LO 4 Explain how to report irregular items.

42. Income statement format:Income from Continuing Operations Ideally, this includes only the normal, recurring, “sustainable” ongoing operating activities of the firm. (2) : Gains and losses that occur infrequently— called: “special” or “unusual” items “ The Line“ These items are included as part of income from continuing operations before tax (sometimes referred to as being reported “ above the line”), they are not disclosed net of tax effects.

43. Income statement format:Transitory items – below the line Nonrecurring items include: Special or unusual items ( above the line) Discontinued operations Extraordinary losses and gains “Below the line” transitory items are always shown net of tax.

44. How common are nonrecurring losses? • Conservative bias of accrual accounting encourages early recognition of declines in asset values below cost or book value but delays recognition of increases in value until after the asset is sold. • Firms’ incentives to separately disclose and clearly label • losses (but not gains) Sample: NYSE/AMEX firms for 1999-2008

45. Reporting Irregular Items Companies are required to report irregular items in the financial statements so users can determine the long-run earning power of the company. Illustration 4-5 Number of Irregular Items Reported in a Recent Year by 600 Large Companies LO 4 Explain how to report irregular items.

46. Learning Objective : How to report a change in accounting principle, accounting estimate, and accounting entity.

47. Accounting Changes (1) (2) (3)

48. (1) Change in Accounting Principle (SFAS 154) • Occurs when changing from one GAAP method to another GAAP method • For example, a change from LIFO to FIFO • Voluntary changes in accounting principles are accounted for retrospectively by revising prior years’ financial statements (for comparability). • Changes in depreciation, amortization, or depletion methods are accounted for the same way as a change in accounting estimate.

49. Prior years’ financial statements that are presented for comparative purposes are restated. Adjusted all accounts balances to reflect what those accounts would have been under the new method. Retrospective Approach

50. (2) Change in Accounting Estimate • Examples: Changes in the estimates of • Inventory obsolescence. • Uncollectible receivables. • Useful lives and salvage values of assets. • Liabilities for warranty costs and income taxes. • Change in depreciation methods.